Understanding the S&P report

Yesterday’s report by Standard & Poor’s on the U.S. government’s credit rating is driving headlines. You can learn a lot more from reading the primary source document than from news coverage of it.

Here is what S&P did:

On April 18, 2011, Standard & Poor’s Ratings Services affirmed its ‘AAA’ long-term and ‘A-1+’ short-term sovereign credit ratings on the United States of America and revised its outlook on the long-term rating to negative from stable.

The news is in the latter part: S&P downgraded its “outlook on the long-term

[credit] rating [of the U.S. government].” This is a warning sign.

S&P told us why they downgraded their outlook:

We believe there is a material risk that U.S. policymakers might not reach an agreement on how to address medium- and long-term budgetary challenges by 2013; if an agreement is not reached and meaningful implementation does not begin by then, this would in our view render the U.S. fiscal profile meaningfully weaker than that of peer ‘AAA’ sovereigns.

… Despite these exceptional strengths, we note the U.S.’s fiscal profile has deteriorated steadily during the past decade and, in our view, has worsened further as a result of the recent financial crisis and ensuing recession. Moreover, more than two years after the beginning of the recent crisis, U.S. policymakers have still not agreed on a strategy to reverse recent fiscal deterioration or address longer-term fiscal pressures.

In 2003-2008, the U.S.’s general (total) government deficit fluctuated between 2% and 5% of GDP. Already noticeably larger than that of most ‘AAA’ rated sovereigns, it ballooned to more than 11% in 2009 and has yet to recover.

The S&P analysts base their outlook downgrade on a legislative assessment that I think is accurate:

We view President Obama’s and Congressman Ryan’s proposals as the starting point of a process aimed at broader engagement, which could result in substantial and lasting U.S. government fiscal consolidation. That said, we see the path to agreement as challenging because the gap between the parties remains wide. We believe there is a significant risk that Congressional negotiations could result in no agreement on a medium-term fiscal strategy until after the fall 2012 Congressional and Presidential elections. If so, the first budget proposal that could include related measures would be Budget 2014 (for the fiscal year beginning Oct. 1, 2013), and we believe a delay beyond that time is possible.

Standard & Poor’s takes no position on the mix of spending and revenue measures the Congress and the Administration might conclude are appropriate. But for any plan to be credible, we believe that it would need to secure support from a cross-section of leaders in both political parties.

If U.S. policymakers do agree on a fiscal consolidation strategy, we believe the experience of other countries highlights that implementation could take time. It could also generate significant political controversy, not just within Congress or between Congress and the Administration, but throughout the country. We therefore think that, assuming an agreement between Congress and the President, there is a reasonable chance that it would still take a number of years before the government reaches a fiscal position that stabilizes its debt burden. In addition, even if such measures are eventually put in place, the initiating policymakers or subsequently elected ones could decide to at least partially reverse fiscal consolidation.

The risk of no agreement on a medium-term fiscal strategy before the 2012 election;

The risk that, if there is an agreement, it will be phased in too slowly;

The risk that delay plus a slow phase-in allows enough time for future policymakers to partially undo an agreement.

I think all three are valid concerns, and I share their skepticism.

They describe other short-term fiscal risks that worry them as well:

the risk of further financial bailouts;

the potential cost of “relaunching” Fannie Mae and Freddie Mac, which they estimate at “as much as 3.5% of GDP (!!!);

the risk of losses on federal loans (they single out student loans).

The first bullet here is scary, and they emphasize it: “Most importantly, we believe the risks from the U.S. financial sector are higher than we considered them to be before 2008.”

S&P comments on three elements of recent deficit reduction proposals: income tax rates, entitlement reform, and the President’s new trigger.

On income tax rates:

Revenue [in the President’s new proposal] would be increased via both tax reform and allowing the 2001 and 2003 income and estate tax cuts to expire in 2012 as currently scheduled—though only for high-income households. We note that the President advocated the latter proposal last year before agreeing with Republicans to extend the cuts beyond their previously scheduled 2011 expiration. The compromise agreed upon in December likely provides short-term support for the economic recovery, but we believe it also weakens the U.S.’s fiscal outlook and, in our view, reduces the likelihood that Congress will allow these tax cuts to expire in the near future.

Note that they are commenting on both the fiscal effects of the deal, and how it affects their assessment of the legislative viability of the President’s recent proposal.

On the President’s new trigger proposal:

We also note that previously enacted legislative mechanisms meant to enforce budgetary discipline on future Congresses have not always succeeded.

This is a poke at the credibility of the President’s trigger mechanism.

On entitlement reform:

Beyond the short-term and medium-term fiscal challenges, we view the U.S.’s unfunded entitlement programs (Social Security, Medicare, and Medicaid) to be the main source of fiscal pressure.

Note that they agree with Chairman Ryan (and me) that entitlement spending is “the main source of fiscal pressure.”

S&P scolds American policymakers by comparing them to their counterparts in other countries. The U.K., France, Germany, and Canada have all begun implementing austerity programs, even while they suffered recessions comparable to or larger than what we had here in the U.S.

S&P concludes with a concrete probability assessment:

The negative outlook on our rating on the U.S. sovereign signals that we believe there is at least a one-in-three likelihood that we could lower our long-term rating on the U.S. within two years. The outlook reflects our view of the increased risk that the political negotiations over when and how to address both the medium- and long-term fiscal challenges will persist until at least after national elections in 2012.

They also tell policymakers the standard against which they will be judged:

Some compromise that achieves agreement on a comprehensive budgetary consolidation program—containing deficit reduction measured in amounts near those recently proposed, and combined with meaningful steps toward implementation by 2013—is our baseline assumption and could lead us to revise the outlook back to stable. Alternatively, the lack of such an agreement or a significant further fiscal deterioration for any reason could lead us to lower the rating.

S&P is telling Washington, that to avoid a possible downgrade, they need to do a deal “in amounts near [$3-4 trillion over the next decade]” and “with meaningful steps toward implementation by 2013.”

As for its political analysis, we simply believe that the prospects are better. We think the political process will outperform S&P expectations. The President is committed, as he made clear in his speech on Wednesday, to moving forward in a bipartisan way to reach common ground on this important issue of fiscal reform. And he believes that the fact that Republicans — that he and the Republicans agree on a target — $4 trillion in deficit reduction over 10 to 12 years — is an enormously positive development. They also agree that the problem exists. So the third part is the hard part, which is reaching a bipartisan agreement. But two out of three is important. And it demonstrates progress.

My view

There is a high probability of incremental spending cuts being enacted this year and next as part of debt limit legislative struggles. I’ll make a wild guess of $100B – $300B over 10 year range.

There is a moderate chance (1 in 3) of an incremental, slightly bigger (maybe $300B – $500B over 10 years) deficit reduction deal before the 2012 election. The President would trumpet such a deal as a good first step, but it appears this would fall far short of what S&P says is needed.

Given the President’s apparent budget strategy, there is at the moment a vanishingly small chance of a big medium-term or long-term deal like that described by S&P as necessary to avoid a possible downgrade, ($3-4 trillion over 10 years, with even bigger long-term changes to Social Security, Medicare, and Medicaid).

The greatest obstacle to constructive negotiations is the President’s attack rhetoric, in which he today accused Congressional Republicans of “doing away with health insurance for … an autistic child” and potentially causing future bridge collapses like the one in Minnesota that killed 13 people.

Maybe the S&P report will scare the President’s team into treating the long-term problem seriously rather than using it as a campaign weapon. I’m not holding my breath.